Q. Consequence of the cash operating cycle?
The cash operating cycle is the length of time among paying trade payables and receiving cash from receivables. It is able to be calculated by adding together the average inventory holding period and the average receivables' deferral period and then subtracting the average payables' deferral period. The inventory holding period perhaps subdivided into the holding periods for raw materials work-in-progress and finished goods. In words of accounting ratios the cash operating cycle is able to be approximated by adding together inventory days and receivables days (receivables' ratio) and subtracting payables days (payables' ratio). If payables are paid prior to cash is received from receivables the cash operating cycle is positive if receivables pay before trade payables are paid the cycle is negative.
The consequence of the cash operating cycle in determining the level of investment in working capital is that the longer the cash operating cycle the higher the investment in working capital. The length of the cash operating cycle differ among industries for instance a service organization may have no inventory holding period a retail organization will have a inventory holding period based almost entirely on finished goods and a very low level of receivables and a manufacturing organization will have a inventory holding period based on raw materials work-in-progress and finished goods. The stage of investment in working capital will thus depend on the nature of business operations.
The cash operating cycle as well as the resulting level of investment in working capital does not depend only on the nature of the business however. Companies within the similar business sector may have different levels of investment in working capital measured for example by the accounting ratio of sales/net working capital as a result of adopting different working capital policies. A moderately aggressive policy on the level of investment in working capital is characterized by lower levels of inventory and receivables this lower level of investment raises profitability but also increases the risk of running out of inventory or of losing potential customers due to better credit terms being offered by competitors. A moderately conservative policy on the level of investment in working capital has higher levels of investment in inventory and receivables: profitability is consequently reduced but the risk of stock-outs is lower and new credit customers may be attracted by more generous terms.
It is as well possible to reduce the level of investment in working capital by reducing the length of the cash operating cycle. This is achieved by decreasing the inventory holding period (for example by using JIT methods) by reducing the receivables deferral period (for example by improving receivables management) or by increasing the payables deferral period (for example by settling invoices as late as possible). In this manner an understanding of the cash operating cycle can assist in taking steps to improve working capital management and profitability.